AMT Filers May Finally Get Some Needed Relief

The IRS has announced that it will suspend the collection of back taxes from tax filers that have a large AMT liability due to the sale of Incentive Stock Options. Congress is FINALLY working to approve legislation that would help taxpayers who exercised ISOs during the "Dot com" boom and subsequent bust cycle of 2000 and 2001.

Let's take an example to show this point. As part of his incentive package, a mid-level manager of Yahoo receives an option to purchase 1,000 shares of the company at a strike price of $40 a share back in 1999. Quickly, the stock rises and goes over $100 a share by the beginning of 2000. The employee decides to purchase his options at $40. But - rather than immediately sell the stock - he decides to hold on to the 1,000 shares.

Since the stock options are an Incentive Stock Option, the employee has to recognize the unrealized gain on the difference between the option price and the market price at the time the shares were optioned. This means that this mid-level manager now has to pay tax on the $60,000 gain ($100,000 value versus his actual cost of $40,000) - even though he has not sold the stock. Why? The ISO purchase places him in the Alternative Minimum Tax category. Not only that, but Mr. Yahoo Manager isn't eligible for the 15% long-term capital gains rate. He now has to pay 26% of income (or 28% - depending on his income). To make matters worse, this poor fella hasn't even sold the stock yet. He decided to keep it. So, he has to find the cash from other savings to pay the tax. Sound like a disincentive to hold company stock as an investment?

Being a dedicated employee, he hangs on to his stock while watching it fall off its high in January 2000. He becomes anxious but knows the stock will come back. So, when his tax bill comes due on April of 2001 - and this Yahoo employee realizes his tax bill - he realizes he now has to sell the shares to pay the tax. But there's a problem. The stock has declined to $10 a share! This AMT tax filer has watched his stock get decimated and now doesn't even have enough net proceeds from the sale to pay his Alternative Minimum Tax!

Under the provisions of what Congress is attempting to pass, taxpayers that were caught in this unfortunate predicament will not get their AMT completely relieved. However, they will be able to speed up the use of the AMT credits that were generated as a result of these transactions. This, in effect, will provide a "relief" of sorts on subsequent tax bills. Thus, the IRS has decided to hold off on collecting these back taxes until the AMT credit can be recognized.

Shared Tax Burden? Spread The Wealth

According to the most recent data from the IRS, the top 1% of filers are now bearing a record share of the income tax burden. In 2006, people with an adjusted gross income of more than $388,800 paid 39.9% of all federal income taxes while earning just 22% of the overall income. This is up from the 2005 data which showed the top "one-percenters" paying 39.4%.

The top 10% - which includes you if you earn more than $108,900 - pull in 47% of adjusted gross income but pay almost 71% of the total tax burden. The culprit? perhaps it is the Alternative Minimum Tax. In 2006, an estimated 3.8 million taxpayers were affected by the AMT and by 2007 that number is expected to grow to 23 million taxpayers.

It certainly doesn't appear that anyone has increased the number of tax breaks to the "wealthy". With record deficits and talk of increasing taxes, the only thing that appears to be increasing is their share of the overall tax burden.

On final interesting thing to note. The bottom 50% pay roughly 3% of the total income tax bill and the lowest income earners actually have a NEGATIVE income tax. Since their income is low enough to get the earned income credit, they qualify to get a refund on income AND payroll taxes.

The Rules of Boot in a 1031 Exchange

"Boot" is a term that you won't find in the Internal Revenue Code. But, if you talk to your accounting professional, you might find it is something he or she uses when discussing the tax consequences of a Section 1031 tax-deferred exchange. I use this short comparison in some of the courses we teach to describe boot..."two cowboys meet out on the range and decide to trade horses. One horse is worth more than the other, so the cowboy with the lesser valued horse, throws in his six shooter "to boot" in the trading of horses.

In modern times, Boot is basically any money or the fair market value of any non-like kind or "other property" received in an exchange. When talking about money, in this context, it should be understood that this includes cash or any cash equivalents - including any debt or obligation the taxpayer assumed by the other party or liabilities to which the property exchanged by the taxpayer is subjected. "Other property" is property that is not like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or "non-qualified property." "Other property" also includes such things as a promissory note received from a buyer (Seller Financing).

Any boot received is taxable (to the extent of exchange gain realized). This is fine when a selling taxpayer desires some cash - and is willing to pay some taxes. Otherwise, boot should be avoided to fully defer the gain in a 1031 Exchange. Boot can sometimes inadvertently appear at closing from a variety of factors. It is important for the exchanging party to understand what miscelaneous items can result in boot if taxable income is to be avoided.

The most common sources of boot include cash boot received during the exchange, debt reduction boot (from trading down in value) and sale proceeds being used to service costs at closing which are not closing expenses. We covered this recently in our article about Closing Costs and 1031 Exchange.

As a recap, the following are examples of some of the non-transaction costs which should be paid with cash brought to closing to avoid "boot":

rent prorata items

utility escrow charges

tenant security or damage deposits

loan acquisition costs

For complete information on the issue of boot, please look at the Rules of Boot section of our Exchange Manual found on the 1031 Corporation Exchange Professionals website.

Market Issues Threaten Investment Mortgage Options

Headlines today are filled with larger banks and mortgage companies in residential real estate lending rushing to raise capital, set aside loan reserves and just simply try to stay in business. Possible government intervention, investor nervousness and changes at Freddie Mac and Fannie Mae in a tightening underwriting market are threatening to topple the mortgage providers and the organizations themselves. While the previous cause for the foreclosure market has been focused on higher loan-to-value loans and faulty or aggressive underwriting, traditional real estate investors are now beginning to feeling the pinch as well.

Earlier this year, Freddie Mac sent an advisory letter to mortgage lenders specifying new product standards. The advisory, now implemented, requires individual real estate investors that obtain loans sold to Freddie to finance no more than four investment properties (previously Freddie capped the number of properties at ten). With Freddie and Fannie responsible for nearly half of the twelve trillion dollar mortgage market in America, many other underwriters have followed suit on the four-property limitation.

You can understand what this drastic change has meant for investment financing options. With the new requirement, real estate investors who already have more than four properties are now unable to refinance their existing loans. This is a potentially big problem for the many investors that have used adjustable rate or fixed initial rate mortgages. As cash flow is squeezed, the change may lead to even greater foreclosure numbers. Those mortgage companies that are continuing to finance investors with greater than four investment mortgages are naturally increasing their costs for providing a mortgage. The rising costs are impacting investment portfolios and dampening tax incentive strategies across the country.

Previously, tax-savvy investors were able to take a mortgage against their primary residence and invest the money in investment property. Many times, these mortgages were larger than $417,000 – the current minimum jumbo mortgage loan amount. The idea was that the return on investment from the property would be higher than the after tax deduction cost of the mortgage interest. However, as investors are forced to pay higher rates on these mortgages, the strategy becomes less attractive.

While real estate investors are definitely more limited today than in the past, they are not completely out of options. It is possible to bypass the four-property rule by taking out a line of credit - rather than a mortgage - at a local bank. Many of these are prime-base products and can possibly be a lower cost option today. Another option is to work with a local or regional lender (1031 Corporation’s parent, FirstBank, is one such option) that holds investment and jumbo mortgages "on their books" as investments and locally underwrites each loan.

Overall, the industry outlook is that the mortgage market is probably going to get tighter. With a hard fought and tight presidential election looming as well as a struggling national economy and financial markets, investor sentiment is that it will take a while for the mortgage market to improve. For investors, that means establishing - or keeping in touch with - strong, trusted local lenders and advisers that are in touch with the rapidly changing mortgage markets.

IRS Guidance and 1031 exchanges

Many times in this blog, we refer to different Internal Revenue Service publications that provide guidance on issues involving real estate and 1031 exchanges. The IRS provides a number of publications and written correspondence that provide guidance. These documents are essentially a translation of tax laws that Congress enacts. we often refer to these when consulting clients on 1031 exchanges. I've listed the top 5IRS publications we use - starting at the highest and moving down according to their "rank".

Regulation
Regulations are the highest form of guidance to new legislation. They are are issued by the IRS and Treasury to also address issues that arise with respect to existing Internal Revenue Code sections. Regulations interpret and give directions on complying with the law.

Revenue Ruling
A Revenue Ruling generally states an IRS position. It is an official interpretation of the Regulation Code or statute. It is, basically, how the IRS applies the law.

Revenue Procedure
A Revenue Procedure is an official statement affecting the duties or rights of taxpayers under the Code, statute, and/or regulations. A Revenue Procedure might provide return filing or other instructions concerning an IRS position. It may also provide a "safe harbor" umbrella with which a taxpayer can structure and complete a transaction.

Private Letter Ruling
A Private Letter Ruling, or PLR, is a statement written to a specific taxpayer that interprets/applies tax law to that taxpayer's specific set of facts. It is issued to establish the tax consequences of a particular transaction before the transaction is completed or before the filing of a taxpayer's return. To receive a PLR, a taxpayer must request a written response from the IRS. It is binding to that taxpayer's circumstances only if the taxpayer is fully and accurately describing the proposed transaction in the request and carries it out as described. It should be noted that while a PLR may provide guidance, it can not be relied on as precedent by other taxpayers or IRS personnel.

Technical Advice Memorandum
A Technical Advice Memorandum, or TAM, is guidance furnished by the Office of Chief Counsel in response to technical or procedural questions that develop during a proceeding. A request for a TAM generally comes from an exam of a taxpayer's return or a taxpayer's claim for a refund or credit. TAMs are issued on closed transactions and interpret the application of tax laws, treaties, regulations, Revenue Rulings or other precedents. The advice is deemed a final position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued.

There are, of course, many other additional publications and pronouncements that provide taxpayer guidance. Robert F. Reilly, CPA, CFA - in a two part article for the AICPA's Practicing CPA, detailed a number of these various publications. Part I covers publications presenting official IRS positions, IRS instructional publications, and announcements, notices, and news releases. While Part II covers advance rulings and determinations as well as new types of IRS pronouncements.

When seeking tax and litigation guidance, tax professionals (CPAs and attorneys) first consider statutory authority. When that is insufficient, they look to these official publications of the IRS as well as judicial precedent (Tax Court rulings)regarding the specific matter.

With respect to 1031 exchanges, your Qualified Intermediary should be monitoring various tax law updates and publications to have the most current weapons to provide you in your arsenal. 1031 Corporation Exchange Professionals has a full time CPA on staff and retains expert tax and real estate attorneys that constantly monitor and update like-kind exchange strategy. While we do not provide tax or legal advice, we can consult with you and your tax professionals and provide guidance as to the proper IRS publications and court case precedent in reviewing your individual exchange facts and circumstances. Further, this consultation is provided as a part of our services and no fee is paid unless an exchange is initiated.

Primary Residence Gain Exemption Rule Changing

Most homeowners are aware of the primary residence exclusion. It is a provision in the tax law that allows a homeowner to sell their primary residence and exempt the gain if certain conditions are met. The gain is available up to $250,000 - if you file your taxes individually - or $500,000 - if you file your taxes if married filing jointly. To be eligible, you must own the home and live in it - as a primary residence - for at least two of the last five years prior to the sale.

The law previously permitted you to convert a vacation, secondary residence or investment property into your principal residence, live in it for two years, sell it and take the full exclusion even though a portion of the gain might have been attributable to periods when the property was used as a vacation, second home or investment property.

This strategy was used for 1031 exchange investors to exempt up to $500,000 of deferred gain in an investment property. In 2004, the Jobs Creation Act made an additional requirement that if a 1031 exchange was involved, you had to own the property for a minimum of five years. thus you could rent a home out for three years, move in it for two and exempt the exclusionary gain.

The Housing Assistance Tax Act of 2008 changes all that. While many provisions within the new law assist struggling homeowners, a provision added takes away from the primary residence exemption rules.

Beginning on January 1, 2009, homeowners will now be required to pay tax on gains made from the sale of a second home, vacation or investment property the portion of time after that date that the home was not used as a primary residence. The amount taxed will be based on the portion of time that the house was not used as a primary residence. The rest of the gain remains eligible for the "up to $500,000" exclusion as long as the two out of five year usage and ownership tests are met. The new law thus reduces the exclusion to the ratio of time used as a principal residence to the total time of ownership.

For example, suppose a married couple filing a joint tax return purchases an investment property after January 1, 2009 and rents it for seven years. They then convert it into a primary residence for three years before selling it. In this situation, only 30% (3/10 years) of the gain would be eligible for the $500,000 exclusion and 70% 7/10 years) of the gain would be subject to tax. Quite a difference.

There is some good news. It is not retroactive. The period of investment use before 2009 is ignored. So is the period of time it is rented after you move out of the residence. Only periods of time it is rented before you made it your residence (after January 1, 2009) count. So, if you've owned an investment property for the past twenty years, move into it before January 1, 2009, and live in it for two years before you sell it, the entire gain remains eligible for the tax exclusion. So, too, is the primary residence that you lived in on January 1, 2009 but later rent out for two years before selling it. The entire gain is eligible for the exclusion.

The Act complicates deferred gains on 1031 exchanges and changes investor strategy for moving into an investment property. 1031 Corporation Exchange Professionals can provide guidance on the issue and, of course, you should speak with your tax advisor to ensure you fully understand your options.

Land Banking & 1031 Exchange

Land banking is not a new concept. It is described as the process of separating real estate activities by forming different business entities that perform investment functions while others complete development activities.

Let's say an investment group forms an LLC and purchases a tract of land for a long-term investment. Over the years, development moves closer to the land and the land increases in value. Perhaps the property is annexed into a municipality, the zoning is changed and a new four lane highway appears. The group decides that, rather than sell it "as is", they would further profit by taking the land through development of the parcel. But wait, they've held it for a long time and they realize that if they develop it, they will get taxed at ordinary tax rates instead of the long term capital gain rate - which is significantly lower. But what if they form a new entity to develop the property? Ah....land banking!

Thanks to a series of favorable court rulings over the past couple decades, owners can sell a property to a separate corporation they control. This corporation then develops the horizontal (and perhaps vertical) improvements and markets the land. By doing so, the former entity - in our example, the LLC - can potentially save significant tax liability on the appreciated value of the land when it is sold to the related corporation by classifying the investment as a long-term capital gain! Jim Walker, the senior tax partner of at the firm Rothgerber Johnson & Lyons LLP explains this process more fully in his article "Land Banking:" A Structured Approach to Capital Gains Planning.

So what would happen if the owners of the LLC decide ahead of the sale that they'd like to reinvest the proceeds of the land sale, to the related corporation, via a 1031 exchange rather than pay the 15% Fed cap gains tax (plus any applicable state or local tax) in order to fully defer the tax?

There is a special rule for exchanges between related parties which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years following the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs. Under this thinking, the development corporation would be compelled to hold the land purchased from the LLC for two years before reselling it.

Tax and exchange professionals have historically advised their clients to comply with the two year rule. However, three Private Letter Rulings (PLRs) released in 2007 say that the two year rule did not apply to a related party who purchased the relinquished property from the taxpayer. The legislative history of Section 1031 identifies several situations intended to qualify under this provision. It includes a non-tax avoidance exception that applies to transactions not involving the shifting of basis between properties.

The purpose of the rule is to prevent related parties from shifting basis from a high basis asset to a low basis asset in anticipation of the sale of the low basis asset that would reduce gain recognition. However, the exchanges in the three PLRs treated the exchanges as valid even though the related buyer voluntarily disposed the property it acquired within two years of the purchase. The rationale used in the 2007 Private Letter Rulings was that the exchanging taxpayer was the only entity that owned property before the exchange. The development corporation did not own property prior to the exchange. Thus, the subsequent disposal did not result in "basis shift" or "cashing out".

So is it possible to land bank a property separating the investment and development activities between entities and then subsequently have the investment entity exchange property? It would appear so - based on recent rulings. Clearly, one need get their legal and tax professional included early on in this process to ensure that you've structured a case that will stand up to potential audit. You also should use the services of a Qualified Intermediary that understands related party issues and knows how to properly process the exchange.